When attempting to look further out into ServiceNow's (NYSE:NOW) 2023 outlook, the most exact quarter offers a glimpse into what the next year could look like.

Investment thesis

For investors looking to invest in long-term secular trends, I think that ServiceNow is a company that is relatively defensive in the current challenging macroeconomic environment that also offers a long-term organic growth opportunity.

The company looks poised to grow its core IT service management and operations business, while leveraging on the strong customer base it has built to expand into new cross-selling and upselling opportunities in the newer employee workflow, customer workflow and creator workflow segments.

At the same time, ServiceNow looks well positioned for strong growth in profitability as the company benefits from a cost structure that improves with increasing economies of scale and sales efficiency. The management continues to expect that their 2026 subscription revenue target of $16 billion plus can be met, this implies a substantial revenue growth opportunity until 2026.

Over time, I am of the view that ServiceNow's operating margins will expand and approach to the levels of the best-in-class software companies. With both revenue growth and improving profitability, the company is poised to become a best-in-class software company.

I have written an earlier article on ServiceNow about the company's defensiveness and long-term organic growth potential.

Execution and guidance supply confidence for 2023

In general, what we saw in the exact third quarter results gave me increased confidence in the company's execution and that things are actually not as bad as the market thinks it to be.

The cRPO for 3Q22 achieved a 150 basis points beat with the 25% year on year growth that it came in at, compared to the guidance of 23.5%.

The beat of 150 basis points warrants further analysis as they mainly came from Federal, and a slight pull forward of the 4Q22 renewal cohort. For reference, this was the best quarter ever for Federal as there was a $20 million deal and a few $10 million new ACV deals. In addition, the pull forward of the 4Q22 cohort to the third quarter was an intentional move and contributed to 50 basis points of the beat.

This showed me that management is able to execute well even as the company faces tough macro challenges. The macro environment remains challenging as management continued to point towards deal spillage continuing and some new businesses being pushed to 2023. I expect that the guidance for 4Q22 already incorporates the weakness in the macro environment and the expectation that management expects further deal spillage and new businesses being pushed to the next year, and furthermore, 2023 guidance will also incorporate some form of weakness as a result of the macro environment. In addition, I like that the deal execution in the 3Q22 quarter was quite encouraging, with the Manufacturing industry seeing strong growth as a result of a large 8-digit deal, while Retail and Hospitality saw 50% year on year growth. In addition, EMEA did really well in the 3Q22 quarter as well, giving further assurance that the deal environment in Europe remains resilient despite the macroeconomic environment.

While I acknowledged that the macro environment remains challenging, I think that the combination of a better managed guidance and idiosyncratic opportunities driven by strong management execution does provide further confidence in the company's abilities to navigate 2023.

Guidance bodes well for 2023

With 50 basis points of pull forward from 4Q22 to 3Q22, I would have expected the guidance to remain reiterated. However, management guided that cRPO growth for 4Q22 to accelerate by 100 basis points to 26% growth year on year. This was a 50-basis point beat to the 4Q22 guidance for cRPO growth.

In particular, I thought it helped Strengthen investor sentiment especially for 2023 as management said in the 3Q22 earnings call that their confidence in the fourth quarter extends to the next year. Furthermore, management stated that the current sales capacity and pipeline coverage are actually better and higher today than at any point in the year of 2022. This does supply me increasing confidence in the deal environment and demand landscape for ServiceNow despite the fears of deals slippages and poor market environment.

4Q22 will be a large renewal cohort for ServiceNow and the management's pull forward of some of those helped to de-risk the numbers for the next quarter. For 4Q22, management still expects to continue to momentum of 98% renewal rate in the quarter, which should be at a similar pace to 3Q22.

In addition, I liked that subscription revenue guidance on a constant currency basis was raised by 50 basis points and is expected to grow by 26% to 27% year on year, which is back to 1Q22 levels. Furthermore, management reiterated full-year operating margins although they experienced 100 basis points of incremental FX pressure. That said, free cash flow margins fell on FX headwinds as well as some additional payment timing impacts.

Macro impact in 2023

I am of the view that 3Q22 results and the earnings call commentary sounded more positive than the prior quarter, when the management actually lowered outlook and mentioned deal delays.

This quarter in 3Q22, they focused more on deals getting pulled forward from 4Q22, while Europe was surprisingly strong and comments that the management sees outlook improving.

That said, management reiterates that the demand backdrop is unchanged, with continued expectations of deal delays in 4Q22. However, the company has better visibility on the business now and the guidance has been reset and takes into account the deal delays and current renewal rates we are seeing. With guidance being reset higher, this also implies that the beat that we might see in 4Q22 might be smaller than in 3Q22.

In addition, with an incremental FX headwind of 100 basis points on operating profit margins and free cash flow margin in 2022, I expect that we can expect free cash flow margin to Strengthen 100 basis points in 2023.

Valuation

Based on both DCF method and EV/FCF multiple method, I equal weight both methods to derive my value for ServiceNow. My assumptions for 2023 include an EV/FCF multiple of 30x for 2023 and a 10% discount rate. As management has mentioned about deal delays and difficult macro in 4Q22 and 2023, I incorporated the conservatism into 2023 to de-risk my forecasts to take into account the challenging macro backdrop.

My 1-year target price for ServiceNow is $531, implying 28% upside from current levels. As ServiceNow has a stronger growth profile and a strong track record of achieving this, as well as its best-in-class renewal rates, I think that the company should trade at premium multiples over peers.

Risks

Competitive pressures

Competition is fierce in the industry in which ServiceNow operates in. Even as a leader in its core ITSM offering, the company faces threats from new entrants into the industry, as well as deep pocket competitors in the industry that wants to expand and grow. These competitors may grow meaningfully and compete with ServiceNow's offerings. This could be detrimental for ServiceNow as its core segment serves as its anchor and differentiating factor that has enabled the company to up-sell and cross-sell over the years. There are other well capitalized competitors like Microsoft (MSFT) and Atlassian (TEAM) that compete with ServiceNow in the ITSM market, with the potential to increase competitive pressures in the industry.

Furthermore, ServiceNow is looking to expand into other workflows, and to be able to gain market share in these segments, it needs to compete with the current incumbents there, who all have their own differentiating factors.

Macro backdrop

With ServiceNow's core ITSM segment seen as a relatively defensive software segment as IT department budgets remain resilient. If the macro backdrop were to show further signs of worsening, this will definitely impact ServiceNow. This may show itself through a slowdown deal flow and slow growth rate for the company.

Execution risk

I highlighted earlier in the article that ServiceNow has shown strong execution, but the company needs to continue that or risk losing its premium multiple attached to it. Management needs to continue to show that they are able to execute well, deliver growth even in difficult macro conditions.

Conclusion

For 2023, while the global macro backdrop remains uncertain, I think that the outlook for ServiceNow looks good. Management is showing strong execution that helps to offset the weak macro backdrop. At the same time, guidance has been de-risked as management has taken into account potential deal slippages and delays into the forward guidance. The fundamentals are also improving as the deal environment continues to look resilient while the pipeline coverage has improved to the best it has been all year. If 2023 turns out better than expected in terms of the macro backdrop, ServiceNow is well positioned to capitalize that. If not, the company remains committed to execute well amidst difficult markets to continue to perform well in the long-term. My 1-year target price for ServiceNow is $531, implying 28% upside from current levels.

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ServiceNow Connects Departments on One Platform in Chicago 

State and local government customers benefit from a platform that can quickly provision IT services internally to customers — their employees — and externally to citizens.

Chicago Public Schools and the city of Chicago engaged ServiceNow through CDW. The school system created an instance in the Illinois Department of Children and Family Services and connected it with CPS. The goal was to enable DCFS to communicate with CPS in a way that’s safe and secure so the two departments could ensure support for teachers and families. 

As a result, people who need social services who are connected with CPS can access DCFS services. Thanks to ServiceNow, both students and schools can benefit from resources available through the city thanks to ServiceNow.

EXPLORE: How localities are using federal grants for IT modernization.

ServiceNow Automates Repetitive Tasks in Denver

Government agencies routinely deal with a large volume of data, and laborious or repetitive tasks can quickly eat up time. As a result, solutions that streamline operations while maintaining accuracy and efficiency are valuable to state and local governments. 

Automation can help. Agencies can apply ServiceNow’s automation capabilities across a wide range of tasks. The automation engine is designed to integrate with other popular platforms and the capability can be built in with minimal coding.

For example, the city of Denver uses ServiceNow to automate its government, risk and compliance processes. Part of the solution involves making it easier for the city’s vendors to fill out a GRC survey. City administrators can choose among 300 questions to create a survey that includes about 125 of the most relevant questions for each vendor. With this process, the city has reported a 66 percent reduction in survey response time.

“We now get responses back in two weeks or less, instead of six — one third of the time — and ServiceNow automatically scores them for us, so we’re not constantly buried in reviews,” says Information Security Manager Julie Sutton. “Our internal clients get much faster turnaround when they need to onboard a new vendor, and our vendors are far happier as well.”

READ MORE: Asset management is a must for successful continuous management.

Denver’s Integration of Additional City Services with ServiceNow

Denver’s ServiceNow solutions have also enhanced its call center experience. With the city’s ServiceNow instance connected to Amazon Connect, information pops up automatically in the calling system. 

The reporting and analytics contained in the city’s ServiceNow instance automatically populate in ServiceNow. This saves Denver’s civil servants a lot of time and frustration.

Say I’m a Denver employee; if I call the help desk, my call actually hits Amazon’s cloud resources. All of my user information, housed in an employee profile, is immediately available to the help desk, which doesn’t have to take the time to ask me certain questions — they already have the information.

CDW’s eProcurement system can connect with ServiceNow’s asset management capabilities. CDW can upload hardware information directly to a customer’s ServiceNow asset management system. So, anything that's purchased through CDW will automatically be put into the portal.

This, of course, prepares ServiceNow to connect to any COTS products — a win-win for state and local governments.

This article is part of StateTech’s CITizen blog series. Please join the discussion on Twitter by using the #StateLocalIT hashtag.

SANTA CLARA, Calif.--(BUSINESS WIRE)--ServiceNow (NYSE: NOW) today announced that it will attend and have executives present at three upcoming investor conferences. These include:

• ServiceNow Chairman and Chief Executive Officer Bill McDermott will present at 2022 RBC Capital Markets Global Technology, Internet, Media and Telecommunications Conference on Tuesday, November 15 at 8:45 a.m. PT. Individuals may access the live webcast of the presentation here.
• ServiceNow Chief Operating Officer CJ Desai will participate in a fireside chat at Credit Suisse 26th Annual Technology Conference on Wednesday, November 30, at 1:20 p.m. PT.
• ServiceNow Chief Financial Officer Gina Mastantuono will participate in a fireside chat at Barclays Global Technology, Media and Telecommunications Conference on Thursday, December 8 at 3:30 p.m. PT.

The live webcasts will be accessible on the investor relations section of the ServiceNow website at https://www.servicenow.com/company/investor-relations/events.html and archived on the ServiceNow site for a period of 30 days.

About ServiceNow

ServiceNow (NYSE: NOW) makes the world work better for everyone. Our cloud-based platform and solutions help digitize and unify organizations so that they can find smarter, faster, better ways to make work flow. So employees and customers can be more connected, more innovative, and more agile. And we can all create the future we imagine. The world works with ServiceNow^TM. For more information, visit: www.servicenow.com.

© 2022 ServiceNow, Inc. All rights reserved. ServiceNow, the ServiceNow logo, Now, and other ServiceNow marks are trademarks and/or registered trademarks of ServiceNow, Inc. in the United States and/or other countries. Other company names, product names, and logos may be trademarks of the respective companies with which they are associated.

ServiceNow (NYSE:NOW) has had a great run on the share market with its stock up by a significant 5.1% over the last month. As most would know, fundamentals are what usually guide market price movements over the long-term, so we decided to look at the company's key financial indicators today to determine if they have any role to play in the exact price movement. In this article, we decided to focus on ServiceNow's ROE.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for ServiceNow

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for ServiceNow is:

4.4% = US$201m ÷ US$4.5b (Based on the trailing twelve months to September 2022).

The 'return' is the yearly profit. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.04.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

ServiceNow's Earnings Growth And 4.4% ROE

On the face of it, ServiceNow's ROE is not much to talk about. We then compared the company's ROE to the broader industry and were disappointed to see that the ROE is lower than the industry average of 12%. Despite this, surprisingly, ServiceNow saw an exceptional 36% net income growth over the past five years. So, there might be other aspects that are positively influencing the company's earnings growth. For instance, the company has a low payout ratio or is being managed efficiently.

Story continues

As a next step, we compared ServiceNow's net income growth with the industry, and pleasingly, we found that the growth seen by the company is higher than the average industry growth of 24%.

Earnings growth is an important metric to consider when valuing a stock. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. This then helps them determine if the stock is placed for a bright or bleak future. Is NOW fairly valued? This infographic on the company's intrinsic value has everything you need to know.

Is ServiceNow Efficiently Re-investing Its Profits?

ServiceNow doesn't pay any dividend to its shareholders, meaning that the company has been reinvesting all of its profits into the business. This is likely what's driving the high earnings growth number discussed above.

Conclusion

On the whole, we do feel that ServiceNow has some positive attributes. Even in spite of the low rate of return, the company has posted impressive earnings growth as a result of reinvesting heavily into its business. The latest industry analyst forecasts show that the company is expected to maintain its current growth rate. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

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Warren Buffett never mentions this but he is one of the first hedge fund managers who unlocked the secrets of successful stock market investing. He launched his hedge fund in 1956 with $105,100 in seed capital. Back then they weren’t called hedge funds, they were called “partnerships”. Warren Buffett took 25% of all returns in excess of 6 percent. 

For example S&P 500 Index returned 43.4% in 1958. If Warren Buffett’s hedge fund didn’t generate any outperformance (i.e. secretly invested like a closet index fund), Warren Buffett would have pocketed a quarter of the 37.4% excess return. That would have been 9.35% in hedge fund “fees”. 

Actually Warren Buffett failed to beat the S&P 500 Index in 1958, returned only 40.9% and pocketed 8.7 percentage of it as “fees”. His investors didn’t mind that he underperformed the market in 1958 because he beat the market by a large margin in 1957. That year Buffett’s hedge fund returned 10.4% and Buffett took only 1.1 percentage points of that as “fees”. S&P 500 Index lost 10.8% in 1957, so Buffett’s investors actually thrilled to beat the market by 20.1 percentage points in 1957.

Between 1957 and 1966 Warren Buffett’s hedge fund returned 23.5% annually after deducting Warren Buffett’s 5.5 percentage point annual fees. S&P 500 Index generated an average annual compounded return of only 9.2% during the same 10-year period. An investor who invested $10,000 in Warren Buffett’s hedge fund at the beginning of 1957 saw his capital turn into $103,000 before fees and $64,100 after fees (this means Warren Buffett made more than $36,000 in fees from this investor).

As you can guess, Warren Buffett’s #1 wealth building strategy is to generate high returns in the 20% to 30% range.

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It has been about a month since the last earnings report for ServiceNow (NOW). Shares have lost about 1.5% in that time frame, underperforming the S&P 500.

Will the exact negative trend continue leading up to its next earnings release, or is ServiceNow due for a breakout? Before we dive into how investors and analysts have reacted as of late, let's take a quick look at the most exact earnings report in order to get a better handle on the important drivers.

ServiceNow Q3 Earnings Beat Estimates, Revenues Up Y/Y

ServiceNow reported third-quarter 2022 adjusted earnings of $1.96 per share, which beat the Zacks Consensus Estimate by 5.95% and improved 26.5% year over year.

Our earnings estimate was pegged at $1.86 per share.

Revenues of $1.83 billion lagged the consensus mark by 1.2% but increased 21.1% year over year. After adjusting for forex, revenues of $1.93 billion jumped 27.5% year over year.

Subscription revenues improved 22.1% year over year to $1.74 billion. After adjusting for forex, subscription revenues increased 28.5% year over year to $1.83 billion, surpassing management’s guidance range of $1.750-$1.755 billion.

Professional services and other revenues increased 4.7% year over year to $89 million. After adjusting for forex, professional services and other revenues increased 12% on a year-over-year basis to $95 million.
 
ServiceNow has been benefiting from the rising adoption of its workflows by enterprises undergoing digital transformation. The company now has 1,530 total customers with more than $1 million in annual contract value, representing 22% year-over-year growth in customers.

Customers with contract value worth $10 million grew 60% year over year in the reported quarter. The renewal rate was 98% in the reported quarter, flat year over year.

During the reported quarter, ServiceNow closed 69 transactions with more than $1 million in new annual contract value.

As of Sep 30, 2022, current remaining performance obligations (cRPO) were $5.87 billion, up 18% year over year. On a constant currency basis, cRPO increased 25%.

Remaining performance obligations, on a constant currency basis, rose 24.5% year over year to $12.1 billion after adjusting for forex.

Operating Details

In the third quarter, the non-GAAP gross margin was 82.4%, which expanded 130 basis points (bps) on a year-over-year basis.

Subscription gross margin of 86.2% expanded 120 bps year over year. Professional services and other gross margins were 7% compared with the year-ago quarter’s figure of 16.5%.

Total operating expenses, on a non-GAAP basis, were $1.03 billion in the reported quarter, up 23.1% year over year. As a percentage of revenues, operating expenses increased 90 bps on a year-over-year basis.

ServiceNow’s non-GAAP operating margin expanded 40 bps on a year-over-year basis to 26.2%.

Balance Sheet & Cash Flow

As of Sep 30, 2022, ServiceNow had cash and cash equivalents and short-term investments of $3.96 billion compared with $3.83 billion as of Jun 30, 2022.

During the reported quarter, cash from operations was $265 million compared with $433 million in the previous quarter.

ServiceNow generated a free cash flow of $103 million in the reported quarter, down from $287 million reported in the prior quarter.

Guidance

For fourth-quarter 2022, subscription revenues are projected between $1.834 billion and $1.839 billion, suggesting an improvement in the range of 20-21% year over year on a GAAP basis. At constant currency, subscription revenues are expected to grow in the 26-27% range.

cRPO is expected to grow 26% year over year on a non-GAAP basis and 20% on a GAAP basis. Unfavorable forex is expected to hurt subscription revenues by $330 million.

ServiceNow expects the non-GAAP operating margin to be 26%.

For 2022, ServiceNow expects subscription revenues to be $6.865-$6.870 billion, which suggests a rise of 23% over 2021 on a GAAP basis. At constant currency, subscription revenues are expected to grow 28.5% over 2021.

Unfavorable forex is expected to hurt subscription revenues by $290 million in 2022.

ServiceNow expects the non-GAAP subscription gross margin to be 86% and the non-GAAP operating margin to be 25%. Moreover, the non-GAAP free cash flow margin is expected to be 29%.

How Have Estimates Been Moving Since Then?

It turns out, estimates revision have trended downward during the past month.

The consensus estimate has shifted -7.02% due to these changes.

VGM Scores

At this time, ServiceNow has a nice Growth Score of B, though it is lagging a lot on the Momentum Score front with a D. Following the exact same course, the stock was allocated a grade of D on the value side, putting it in the bottom 40% for this investment strategy.

Overall, the stock has an aggregate VGM Score of D. If you aren't focused on one strategy, this score is the one you should be interested in.

Outlook

Estimates have been broadly trending downward for the stock, and the magnitude of these revisions indicates a downward shift. Notably, ServiceNow has a Zacks Rank #3 (Hold). We expect an in-line return from the stock in the next few months.

Performance of an Industry Player

ServiceNow belongs to the Zacks Computers - IT Services industry. Another stock from the same industry, Infosys (INFY), has gained 5.5% over the past month. More than a month has passed since the company reported results for the quarter ended September 2022.

Infosys reported revenues of $4.56 billion in the last reported quarter, representing a year-over-year change of +13.9%. EPS of $0.18 for the same period compares with $0.17 a year ago.

For the current quarter, Infosys is expected to post earnings of $0.19 per share, indicating a change of +5.6% from the year-ago quarter. The Zacks Consensus Estimate remained unchanged over the last 30 days.

Infosys has a Zacks Rank #4 (Sell) based on the overall direction and magnitude of estimate revisions. Additionally, the stock has a VGM Score of C.

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